Private equity firms have historically invested in portfolio companies treated as corporations for state income tax purposes, limiting the state income tax impact of portfolio company operations and asset liquidations at the private equity and owner levels. However, as portfolio company investments have shifted from the corporate form to flowthrough and disregarded entities, such as partnerships and limited liability companies (LLCs), the private equity space has become inundated with state income tax issues and traps for the unwary, triggered by complex state-to-state variations in the treatment of tiered flowthrough entities and fundamental differences between the state income tax treatment of flow-through entities and corporations.
Stress points that often produce significant difficulties include apportionment issues stemming from the mixed entity and aggregate treatment of flowthrough entities, the attribution of nexus up and down tiered flowthrough structures, and the impact on individual owners of residency rules and unusable credits for taxes paid to other states. At no point are these items brought into greater magnification, both in their separate capacities and as a tangled whole, than when a private equity firm enters into a deal to sell a portfolio company.
Consider the following example, which illustrates a fairly common scenario:
Example: Company X is a private equity firm legally and commercially domiciled in New Jersey. Individual A, a New Jersey resident, owns 20 percent of Company X. In 2010, Company X purchased 100 percent of Company Y, an LLC legally and commercially domiciled in New Jersey with activities conducted wholly within the state. Company X successfully operated Company Y and expanded its business operations to a number of other states. In 2015, A, whose personal tax adviser suggested that he move to a warmer climate, became a resident of Florida. In late 2015, Company X entered into a deal closing in mid-January 2016 to sell to a third party substantially all of Company Y’s assets, the vast majority of the value of which is tied up in zero-basis goodwill and customer lists. In the few weeks of 2016 before the sale, Company Y had a relatively small amount of apportionable income from operations in New Jersey and the other states in which it did business.
In this scenario, Individual A would have a significant state income tax problem. Company X would be required to remit to New Jersey a withholding tax on behalf of A for A’s 20 percent share of Company X’s income, including Company Y’s 2016 operating income and the income from the sale of Company Y’s assets, apportioned to New Jersey (N.J. Stat. section 54:10A-15.11(a)). For apportionment purposes, New Jersey uses a single-sales-factor approach, under which income is sourced to New Jersey-based upon the ratio of New Jersey-sourced receipts to total receipts. Receipts for purposes of computing the sales factor include net gains from sales of goodwill and customer lists, and those net gains are New Jersey-sourced receipts if the commercial domicile of the seller is in New Jersey (see N.J. Admin. Code tit. 18, sections 18:7-8.9 and 18:7-8.12).
Furthermore, many of the other states in which Company Y does business would require withholding but would apply a different approach to apportionment, potentially resulting in substantial multiple withholding taxation. Lastly, A, as a resident of Florida, would have no resident income tax credit relief from these taxes because there is no individual income tax in Florida and, therefore, no credit for taxes paid to other states.
Balking at having to pay all this state individual income tax, Individual A threatens to block the deal unless Company X fixes the “withholding problem.” What can Company X do? A possible simple solution is to distribute Company Y membership units to A in exchange for his units in Company X and then to have Company Y redeem out A before the asset sale. It is arguable that this redemption transaction would be treated as the sale of a membership interest in an LLC by A, which, according to the general approach among the states that an individual taxpayer who is not a resident of the state at the time of the sale of an interest in a flow-through entity is not required to include the gain from the disposition as income from in-state sources on the individual’s nonresident tax return, would be taxable to A by Florida. Accordingly, A’s only apportioned income subject to withholding tax in 2016 in states other than Florida would be his proportionate share of the relatively small amount of operating income of Company Y earned in the first few weeks of the year. Problem solved? In a word, no.
Although New Jersey follows the general approach among the states regarding sourcing gain from the sale of an interest in a flow-through entity, the state does so with one peculiarity that is significant in individual A’s case. Under New Jersey Division of Taxation Bulletin GIT-9P, if a nonresident individual taxpayer has any income from New Jersey sources in the year of the disposition of an interest in a New Jersey flowthrough entity other than the gain from the disposition, the non-resident is required to source the gain from the disposition to New Jersey as if the nonresident were a resident of the state.
Accordingly, because Company Y is a New Jersey LLC and A has a distributional share of Company Y’s operational income from the first two weeks of January, some of which was sourced to New Jersey, the state would require A to pay New Jersey individual income tax on the gain from the sale of his interest in Company Y. This would likely leave A in a worse position vis-à-vis New Jersey, and potentially even overall than before the restructuring and redemption.
Thus, in this situation, additional transactional planning and restructuring would be necessary to take into account the impact of Bulletin GIT-9P, likely increasing the costs of the transaction and possibly upsetting the delicate balance among the players in the run-up to closing the deal. Furthermore, although New Jersey’s approach to sales of flowthrough entities is unusual and may be subject to challenge, every state has traps for the unwary that can severely skew the state income tax impact of a private equity firm's endgame for its portfolio companies. To mitigate the effect of these traps, private equity firms and their owners should regularly review the state income tax implications of their operations and should heighten scrutiny early in the disposition process.
Excerpted from the April 2016 issue of The Tax Adviser. Copyright © 2016 by the American Institute of Certified Public Accountants, Inc.